Cleveland Fed research sheds new light on post-crisis banking concern

Lab experiments could provide guidance on design of contingent convertible capital (CoCo) bonds

Quick Take:

• Two laboratory studies focused on the effects of different price triggers on contingent convertible capital bonds, also known as CoCo bonds
• CoCo bonds are bank-issued debt that can convert to equity for the purpose of recapitalizing a bank in financial distress and have been issued in some European countries
• Various triggers for this conversion have different impacts, which should be taken into account when designing these securities

New research from economists Edward Simpson Prescott at the Federal Reserve Bank of Cleveland and Douglas Davis at Virginia Commonwealth University utilizes two sets of experiments to study the impact of different triggers for the conversion of debt-to-equity in contingent convertible capital bonds, also known as CoCo bonds.

In the experiments, volunteers playing the role of traders buy and sell assets and different price triggers are used to determine whether or not the bonds being traded will convert from debt to equity thereby changing the price. The study tracks the impact of both fixed-price triggers and triggers in which a regulator decides on conversion based on prices that he or she observes.

Prescott and Davis find frequent conversion errors particularly when regulators are presented with “inside” information about the fundamental value of the asset not available to traders. The findings suggest that the mechanism to be preferred depends on the extent to which conversion dilutes equity, information that should be useful to those who design these securities.

Read the study “Using Economic Experiments to Improve Contingent Convertible Capital Bonds” here.

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.455.4479